The country faces difficult questions: Can bubbles in stock and real estate prices be deflated without hurting employment and output? Can a construction sector swollen by years of overbuilding return to normal levels? Will unsustainable imbalances in the flows of money in and out of the country return to equilibrium without disrupting the economy?
Yes, the United States does face challenges. But the country I have in mind is China, and the problems it faces as a result of faulty economic policies are even more daunting than our own.
But because of the strange symbiotic relationship the U.S. now has with China, how each responds to its own deteriorating economy will influence how well the other weathers its rough seas.
In many ways, the economic policies of China and the United States are mirror images of each other. China has large net exports of goods. We are a large net importer. China has a high savings rate and has lent much money abroad. Our savings rate is near zero, and we have borrowed much from abroad. China fosters producers at the expense of consumers. We do the opposite.
But what is proving to have been folly for us – encouraging household consumption and growing indebtedness, running large government budget deficits and borrowing large sums from abroad – does not mean China’s mirror-image policies were prudent. Both countries chose policies driven by short-term political considerations that carry long-run harmful consequences. And both followed monetary policies that, at least in retrospect, expanded each nation’s money supply far too much.
From Alan Greenspan’s “irrational exuberance” speech in December 1996 to now, the U.S. money supply, broadly measured, increased 94 percent. Real output of goods and services increased 37 percent. One need not be a Milton Friedman groupie to wonder where all that the extra money went.
Consumer prices increased 32 percent. The Gross Domestic Product deflator, a much broader price measure than the Consumer Price Index, increased only 27 percent. So some excess money growth went into higher product prices. But there still was money left over. That pushed stock and real estate prices higher than would have occurred with slower money growth.
China printed yuan to buy up foreign currencies, largely the U.S. dollar. Just a few years ago, China’s foreign currency holdings were $400 billion and then a trillion. Now they top $1.4 trillion.
In theory, a country like China could buy up dollars without any net increase in its own money supply. But that is not practical at the scale of China’s dollar purchases. So its efforts to keep the dollar expensive compared to the yuan meant it had to increase the Chinese money supply. This stokes inflation, both in the prices of consumer goods and services, but also in real estate and stock prices.
The Chinese bought up dollars and other currencies to keep their own money cheap relative to other currencies. That keeps Chinese exports cheap abroad and stimulates the country’s domestic output and employment.
This economic stimulation from burgeoning exports compounded the general stimulus of a growing money supply. As in the United States, money poured into Chinese construction, mostly commercial property, and into stock markets. The Shanghai stock market index increased 511 percent in the two years ended in October. The Dow increased only 37 percent in the same period.
China created money and lent it to us so that we could buy its exports. Cheap imports from China kept U.S. inflation down. Cheap Chinese loans kept U.S. interest rates low even as we increased the U.S. national debt by 53 percent since 2001. These loans also allowed more dollars to flow into U.S. real estate and stock markets, causing bubbles that now are deflating painfully.
U.S. real estate and stock prices are retreating. The economy is slowing. Some financial firms are going bust. This largely was inevitable.
The same thing has to happen in China, but it will be much more painful. Hard economic times often are more threatening in nondemocratic nations than in democracies because dictatorships have no widely accepted legitimacy on which to fall back. Unemployment, inflation and falling stock prices all pose dangers to China’s authoritarian government. Rapid growth has imposed enormous strains on Chinese society. The slowing of that growth, even if only temporary, will impose even more.
China needs to stop buying up U.S. dollars to keep the dollar expensive. It needs to slow growth of its domestic money supply. Its own real estate and stock market bubbles need to deflate a bit. If China does not act by choice, market forces eventually will impose even more brutal adjustments.
It is not clear however, that Chinese leaders know how to implement such adjustments, even if they come to accept that they are necessary. You may have heard that the saying, “May you live in interesting times,” is a Chinese blessing-curse. The first use appears to have come from a Western writer, but it applies just as well on either side of the globe.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.